We're always being reminded to save for retirement in tax-advantaged accounts like 401(k)s or IRAs. But did you know the government does an about-face and forces us to take money out of those accounts once we reach retirement? It's called the required minimum distribution (RMD) rule. Here are some tips you should know about RMDs well before you reach retirement age.
RMD penalties are high. RMD rules require you to withdraw a certain amount of money every year from tax-deferred retirement plans like 401(k)s and traditional IRAs after you reach age 70½. These withdrawals are then taxed as ordinary income. If you don't follow the rules, the IRS can assess a penalty equal to 50 percent of the amount that should have been withdrawn, on top of the regular tax due.
Start thinking about RMDs early. One of the biggest mistakes retirees make is waiting until age 70½ to start thinking about RMDs. Remember, you can start withdrawing funds without penalty after you reach age 59½. If you start planning a tax-efficient withdrawal strategy before RMD rules kick in, you can manage what tax rate will be applied to your retirement distributions. With careful planning, smart taxpayers can easily reduce the federal tax rate they pay on their retirement distributions by 5 percent or more.
The ½ year start date is confusing. You don't have to start taking RMDs until April 1 of the year after you turn 70½. For example, if you turned 70½ on July 15, 2018, you wouldn't have to take your first RMD until April 1, 2019. However, after that first year, RMDs will be due by Dec. 31 on every year afterward (including on Dec. 31, 2019 in this example).
RMD amounts are based on complex tables. How much you're required to withdraw is based in part on the average life expectancy of someone your age. A calculation based on complex IRS life expectancy tables, plus your retirement account balance in the prior tax year, is used to determine your RMD. The good news is that the financial institution handling your retirement account will usually do the calculation for you.
There are exceptions to distributions if you still work. If you reach 70½ and you’re still working for an employer providing you with a 401(k), you usually don't have to take an RMD from that account as long as you don't own 5 percent or more of the company. However, you still must take RMDs from other plans where you have assets.
Not all accounts require distributions. Remember, not all retirement accounts require you to take an RMD. Roth accounts, for example, are exempt from RMDs and give you some extra flexibility to manage your other taxable withdrawals during retirement.
RMD rules can be confusing and are a good example of why tax planning is such an important component of a retirement strategy.